Lesson 2: Credit Instruments PDF

Lesson 2: Credit Instruments Learning Outcomes: At the end of the lesson, student’s will be able to :  Discuss the definition and nature of credit instrument.  Describe the instruments used by an individual, banks and other financial institution in a cr...

Lesson 2: Credit Instruments Learning Outcomes: At the end of the lesson, student’s will be able to :  Discuss the definition and nature of credit instrument.  Describe the instruments used by an individual, banks and other financial institution in a credit transaction.  Differentiate the types of checks and drafts  Interpret the legal aspects relating to credit instruments. A. Introduction Credit plays a significant role in modern business and that part is represented by credit instruments. These are written or printed or typed financial documents that serve either as promises to pay or as orders to pay. They provide the means by which funds are transferred from one party to another. B. Credit Instrument Defined: Credit Instrument - is a written evidence of the existence of credit contract entered into between the creditor and debtor. It is a written agreement evidencing the existence of debt that gives a legal claim to the creditor against the debtor. C. Nature of Credit Instrument: A credit instrument becomes an evidence that there exists a credit transaction. It starts after the creditor has accepted the application of borrower. D. Characteristics of Credit Instruments: 1. presence of risk – means the possibility of non-payment in the future. 2. stress on the debtor-creditor relationship – an agreement between the borrower and the lender. E. Importance and Advantages of Credit Instruments: 1. Clear & Definite details of the transaction can be stipulated by the parties. The obligations of the debtor as well as the rights of the creditor are spelled out in the instrument, including the rate of interest and terms payments. 2. Credit instruments can be transferred to third parties. It can be used as collateral in securing loans to third parties. 3. It is an incontestable proof of creditor. In cases of court proceedings, lender has an undefeatable proof of evidence. F. Classifications of Credit Instruments: 1 1. As to Acceptability 1.1 Unlimited Acceptability – those pass from one hand to another hand without question as to their source and possess the characteristics of money. E.g. government bank notes and treasury certificates 1.2 Limited Acceptability - those whose acceptance depend on the credit standing of the issuer or maker. E.g. checks, postal money orders 2. As to form 2.1. Order to pay – refers to the order of a person to second person to pay a third person a certain sum of money on demand or at a determinable future time. 2.2 Promises to pay – contain the promise of one person to pay another a certain sum of money on demand or at a determinable future time. Parties involved in an order to pay : a) drawer – one who gives the order b) drawee – one who is ordered to make payments c) payee – one who receives the payment. Classes of Orders to Pay: a) Check –an order of a depositor to his bank to pay a certain sum of money to a third party or himself on demand. This is subject for payment. Kinds of Checks:  Order or Bearer Check - a check payable to the order of specified individual or company or to the bearer of the instruments. A bearer cheque is a type of cheque that is payable to the person who possesses it, without any restrictions or conditions. An order cheque is a type of cheque that is payable only to the person or organization indicated on the cheque. The payee must endorse the cheque by signing it on the back before it can be cashed or deposited. Feature Bearer cheque Order Cheque Payee Anyone who possesses the cheque Only the named payee Security Less secure as anyone who possesses the More secure as only the named cheque can cash it payee can cash it Endorsement Not required Required by the named payee Convenience May be less convenient for the More convenient for the payer, as they do not payer, as they need to name a payee need to name a payee and wait for the payee to endorse the cheque 2  Legal Status Legal in some countries, but not in others Legal in most countries, but subject to certain regulations and restrictions  Crossed Check – a check that cannot be presented to the bank for cash payment but to be deposited in the account of the payee in his bank. It is easily recognized by the presence of two (2) parallel lines on the top left-hand corner of the check. Fig.1 An example of crossed check Fig. 2 An example of Certified check  Certified Check - a check which has been certified by the bank official as to the sufficiency of funds covering the amount on the face of the check. The word certified is stamped on the face of the check within the signature of the certifier.  Cashier’s/ Manager’s Check - the bank’s order to pay drawn upon itself & signed by the cashier/ manager payable to the person or firm designated by the depositor. Certified check Similarities Cashier’s check Funds are withdrawn from  More secure than Funds are moved from personal account and personal check. personal account to bank’s frozen until the check is  Often used in large account until cashed out. cashed out. purchases.  Authorized by financial institutions.  Service Fees may apply Table 1. Difference and Similarities of Certified check and Cashier’s/manager’s check  Post-dated check – a check which is issued by the drawer showing a future date, hence it should not be presented for payment before the date it bears , nor will it be acceptable for deposit.  Stale Check - a check which is not presented to the bank for cash payments nor deposited to the payee’s account after six (6) months from the date it bears. It is a six-month old check.  Traveler’s Check – a form of check that is not drawn on any particular bank it is payable anywhere throughout the world.  Counter Check - is used by a depositor who wishes to withdraw all his money from his account but whose check booklet has been exhaust.  Bouncing Check - a check which has no sufficient funds. Other classification of checks:  Bank “On-Us” Checks – checks that are drawn on a particular bank branch only.  Local clearing checks – these are drawn against other banks within the locality. 3  Regional Clearing checks – these are checks drawn aginst banks in provinces with BSP regional clearing.  Manila Clearing checks – these are checks drawn against banks branches in Manila with BSP with BSP clearing. b) Draft -are orders to pay and are drawn by a drawer against a drawee to pay a third party, a certain sum of money on demand or at a future determinable time. These are orders to pay that are subject for acceptance. Types of Drafts:  Money order - may either be a bank order or postal money order Bank money order – when the order is drawn by a bank to another bank to pay a specified payee. Postal Money order – when the order is from one post office to another post office to pay a specified payee. The buyer of money order receives the draft in exchange for cash and he also pays a nominal service charge.  Bank draft - an order of a bank to another bank or the depositor to his bank to pay a third person a definite sum of money.  Trade/ Commercial Draft - an order drawn by a seller on the buyer or another business firm to pay a certain sum of money to bearer or o a third party on demand or at a fixed future time.  Sight/Demand Draft = a draft which is payable at sight or upon presentation of the draft by the holder.  Time Draft = is a draft wherein the order to pay sets a definite determinable future time for payment. c) Acceptance = is originally a draft presented for acceptance to the drawee and when the drawee accepts the draft  it becomes now an acceptance, hence, the drawee is now liable for the payment of the draft at maturity. Types of Acceptance:  Trade acceptance - is an order of the seller on the buyer to pay a certain sum of money at a stipulated future time. If the buyer accepts the terms, he annotates the draft with the word accepted across its face together with his signature & the date of acceptance.  Bankers’ Acceptance = when an order to pay is presented to a bank for its acceptance. If the bank accepts the terms, the word accepted is stamped on the face of the instrument & it will be signed and stamped with the date of acceptance. 2.2 Promises to Pay - contain the promise of one person to pay another a certain sum of money on demand or at a determinable future time. 4  Parties involved in Promises to Pay: a) maker - person promising to pay b) payee - person to receive payments Classes of Promises to Pay: a) Open Book Account - implies the verbal promise of the debtor when he buys consumable goods of credit and this is otherwise known as charge account. The creditor enters the account in his notebook to show the existence of credit transaction. b) Promissory Notes - an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand or at a fixed future time a certain sum of money to order or to bearer. Kinds of Promissory Notes:  Single-name promissory note - one that bears only the name of the maker.  Two-name or double-name -one that bears the signature of 2 persons – the maker and co- maker.  Collateral/ Secured Promissory Note - one in which the collateral is described on its face or one a separate document. The value of the collateral shall be over and above the loan granted.  Commercial Letter of Credit = a written promise on the part of the bank to honor drafts drawn against it or for its account by a specified beneficiary or his order under the specified beneficiary of his order under the specifications contained in the letter of credit. A letter issued by a bank at the request of a buyer authorizing the seller to draw drafts against the bank for a designated sum of money payable at a specific time. Parties to a Commercial Letter of Credit: Buyer or Importer - the buyer of merchandise who will initiate the letter of credit. Seller of Exporter - the party who is to receive the letter of credit. Opening Bank - bank of the buyer that issues and undertakes the letter of credit for the account of the buyer. It will notify the beneficiary that the letter of credit has been opened. Negotiating Bank - bank of the seller instructed to pay the letter of credit. 5  Fig. 3 The flow of the commercial letter of credit Mechanics of a Commercial Letter of Credit: Letter of Credit is initiated by the importer, that is, he makes arrangement with his bank to open a letter of credit in favor of the exporter. The establishment of a line of credit between the importer and his bank precedes the opening of a letter of credit. Types of Commercial Letter of Credit: a) As to Transmission  Circular = when the opening bank issues a letter addressed generally to persons or corporation indicating its intention to honor the drafts of the beneficiary under the terms specified therein.  Specially Advised = when the opening bank notifies the beneficiary directly of through a notifying bank. b) As to Duration  Revocable - when the bank has the right to cancel the credit before negotiations without prior notice to the beneficiary. This is no longer allowed by the Philippine banks with a resolution of the MB of BSP.  Irrevocable = when the bank waives its right to cancel of notify the credit prior to negotiations. Here, the exporter is accorded greater protection since the importer cannot cancel the order. c) As to Obligations of the Negotiating Bank  Confirmed - when the notifying bank upon instructions of the opening bank assumes the obligation to perform the undertaking stipulated in the letter of credit. The liability of the bank of the importer is also the liability of the bank of the exporter, hence, the exporter enjoys the protection of 2 banks.  Unconfirmed - when the bank of the exporter does not assume any other obligation except that of notifying the beneficiary, in short, it acts only as the advising or paying agent for the issuing of bank. 6 3) As to Function 3.1 Credit money -emphasizes its use as a medium of exchange e.g. gov’t credit money, bank credit money. 3.2 Commercial credit money - used to facilitate the use of credit in short-term commercial activities. e. g. checks, drafts, acceptances promissory notes, etc. 3.3 Investment credit/investments - used for long-term credit e.g. bonds, stock certificate. 4. As to Negotiability 4.1 Negotiable - these must contain the following essentials of negotiability:  the instrument must be in writing; o there must be an unconditional promise or order to pay;  there must be a determinable time for payment; o there must be an indicated definite sum of money;  it must be signed by the drawer or maker of the instrument; and o it must be made payable to order or bearer on demand. 4.2 Non-negotiable = those instrument that lacks the essentials of negotiability. e. g. open book account. Legal Aspects Relating to Credit Instruments: Negotiation = the transfer of the instrument from one party to another party either by:  Presentment - exhibiting of the instrument at the bank either for payment or for acceptance.  Dishonor - this means that the instrument is refused payment or refused acceptance.  Endorsement - is simply indicated by the signature of the endorser at the back of the instrument or on some paper attached thereto. Kinds of Endorsement:  blank endorsement - the printing of one’s name and signature at the back of the instrument without specifying the indorsee.  full/special endorsement - one in which the indorser specifies the person to whom or whose order the instrument is to be payable. 7  restrictive endorsement - an endorsement that prohibits the further negotiation of the instrument.  qualified endorsement - is one that limits the liability of the endorser. It is made by writing the words “without recourse”.  conditional endorsement - is a special endorsement to which words are added that create a condition which must happen before the endorsee is entitled to payment. Holder in Due Course - is one who accepts the instrument with the understanding that:  it is complete & regular on its face;  he became holder before its maturity;  he possesses no knowledge that the instrument has been dishonored;  he has no knowledge of any defect of the instrument; and  he accepted the instrument in good faith and for value received. 8  References : Mutya, Ruby F.A (2014) Introduction to Philippine Money, Credit and Banking. 3rd ed. National Book Store,Mandaluyong City, Philippines “Money, Credit and Banking”. Rose Marie B. Laman & Vincent Patrick B. Laman. GIC Enterprise & Co. Inc., Recto Manila (2015) Urbis, Corazon B., Fin 105 Credit Analysis and Collection: Instructional Manual, (Unpublished) Updated, 2016. Bragg, Steven M. (2017) Credit & Collection Guidebook: Third Edition. Accounting tools, INC. Centennial, Colorado.2017 The Editorial Team. (2023, July 18). Difference between Bearer Cheques and Order Cheques (Bearer Cheques vs Order Cheques) (2024). onlydifferences.com. https://onlydifferences.com/difference- between-bearer-cheques-and-order cheques/#:~:text=The%20main%20difference%20between%20bearer,and%20convenient%20method%2 0of%20payment. Mint. (2022, July 11). What is a certified check? MintLife Blog. https://mint.intuit.com/blog/money- etiquette/what-is-a-certified-check/ Team, W. (2024, January 5). Endorsement. WallStreetMojo. https://www.wallstreetmojo.com/endorsement/ 9